Cliffs Natural Resources: Let's Discuss The Price Target

| About: Cliffs Natural (CLF)

Summary

Cliffs shares rallied this year.

Some investors argue the company is overvalued, while others believe the current upside is just the beginning.

Let's discuss the price target for Cliffs.

Not surprisingly, target price is the common topic in the comments section of articles on Cliffs Natural Resources (NYSE: CLF). Estimates vary widely, from statements that Cliffs shares belong to the sub-$2 territory to ambitious targets of $40 per share.

In this article, I am going to speak about the really long-term perspective - how much the company's shares might be worth when Cliffs' transformation ends and it will be entirely focused on the U.S. business.

One thing that I'd like to mention before we proceed is that you don't need to know past prices of Cliffs shares to evaluate possibilities for the future. Yes, at one point the shares were worth $100, but this was a different company in a different world. Cliffs now has no Canadian assets and no coal business. In the future, the company will have no Australian iron ore exposure as the mines in Australia age. In this light, looking at the past provides no insights for the future.

The U.S.-focused Cliffs will mostly depend on the health of the domestic steel industry rather than on iron ore prices, although iron ore prices will remain included in some form in the contracts. As the recent 10-year contract with Arcelor Mittal (NYSE: MT) showed, the company will likely have no problems getting customers in the next decade. So, we can safely bake in production and sales expectations that are close to current numbers.

On the iron ore price side, I'd be conservative and assume that a $40-50 range will continue in the future. BHP Billiton's CEO Andrew Mackenzie recently stated that 10 years may be needed to reach a balance in iron ore market. While you can be skeptical about the commentary from one of the architects of the current iron ore price misfortunes, this scenario looks plausible. Despite problems, iron ore majors seem unwilling to change their tactics, which could create further pressure on iron ore prices in the future.

A recent bearish take on Cliffs here on SA implied that the company's well-being depended on "protectionist tariffs", and that "gains coming from politics [...] could evaporate as fast as they materialized". I have a different view. It took a long time for tariffs to be implanted, and it will likely take an equally long time to lift them. However, for the sake of conservatism, I'll use a modest price assumption for Cliffs' pellets.

So, here's what we have in our hypothetical scenario. I use extremely conservative assumptions of pellet price, and remind you that Cliffs sold its pellets for $83.87 per ton in the first quarter of this year.

Revenue

Let's proceed and calculate EBITDA based on the cost assumption of $55 per ton and look at the potential EBITDA:

EBITDA

How much times EBITDA could the company be worth? Let's look at various scenarios:

Enterprise value

Before proceeding to the stock price, let's deal with debt. Assuming no catastrophic developments on the iron ore front, Cliffs must decrease its debt level by the time its Australian mines are closed. At the end of the first quarter, the company had $2.5 billion of long-term debt. The recent filing stated that the company may raise up to $300 million via share offering and will use the proceeds to deal with debt. Combining these proceeds with positive cash flow from operations, Cliffs must bring the debt to $2 billion. In my view, this is absolutely not the base-case scenario, but for the sake of a conservative assumption, we'll use a $2 billion debt level first:

Enterprise value - Debt

Now we are ready to look at the stock price (the share count is adjusted for future dilution):

Stock price

The stock price ranges from $2.17 in the worst case to $13.04 in the best case. I reiterate that I used extremely cautious inputs that implied almost no upside in the markets at all, especially on the pricing front. I believe the potential upside is greater than $13.04 in the longer term. To illustrate this, I'll change the price scenarios to $85, $90 and $95 per ton and reduce debt to $1.5 billion (which is logical, as higher pellet prices imply higher iron ore prices as well, help Australian iron ore and magnify opportunities to reduce debt).

Stock price - Scenario 2

All in all, I believe in significant upside for Cliffs in the long term. In the short term, watch out for Brexit. If Brexit happens, the dollar will rally and commodities stocks will be beaten. As I always stated, CLF is better bought on pullbacks rather than on breakouts, so the unlikely Brexit might provide an opportunity to enter a position.

Disclosure: I am/we are long CLF.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.